Understanding “De-leveraging,” Meredith Whitney on Credit Cards
December 2, 2008 – 11:30 am
If you want to understand de-leveraging, you could do worse than Meredith Whitney’s op-ed in yesterday’s Financial Times. She noted that $3 trillion of credit had been “expunged” from the economy so far this year. She also said credit card lines could be substantially reduced:
I estimate that the mortgage market will shrink for the first time in US history and that the credit card market will be 18 months behind it. While just over 70 per cent of US households have access to credit cards, 90 per cent of these people use credit cards as a cash-flow management vehicle, or revolve payments at least once a year. While the credit card market is small relative to the mortgage market, it has grown to play a key role in consumer liquidity. Declining liquidity here will have disastrous effects on consumer spending and the economy. My primary concern is preserving liquidity to consumers, who command more than two-thirds of gross domestic product.
This makes complete sense when you consider the leverage ratios of the big banks. As I wrote a week ago, Citi has $2.1 trillion of on-book assets and $1.2 trillion of off-balance sheet assets compared to less than $10 billion of tangible common equity. Depending on how much of those off-balance sheet assets have to be taken back onto the balance sheet, Citi’s leverage ratio is impossibly high for the bank to keep operating without government guarantees.
If I’m reading their financials correctly, and I think I am, in addition to the $3.3 trillion of on/off balance sheet assets, the company has another $1.3 trillion in untapped credit commitments (see page 78 of the most recent quarterly filing), over 70% of which is for untapped credit card lines. If you’ve got a Citi card with an outstanding balance of $3,000 and a credit limit of $10,000, then Citi stands ready to provide you with $7,000 of additional credit on demand. As other forms of credit (like Home Equity Loans) disappear, consumers will turn to more expensive funding sources like credit cards to help them get by. So as those credit lines are tapped, the additional credit goes onto the asset side of Citi’s balance sheet, increasing leverage.
The trouble, of course, is that Citi’s balance sheet is already over-leveraged relative to its tangible equity. It doesn’t have the balance sheet capacity to expand credit. In fact, to protect itself and taxpayers (who now implicitly back the company’s debts) it must reduce its credit commitments significantly in order to reduce its leverage ratio.
This is “de-leveraging.” It’s what happens during a “credit crunch.” Those employing too much leverage to begin with, like all the banks, have to shrink their balance sheets by crunching credit: cutting credit lines, selling good assets and raising capital (either from the government or privately). Leverage = Assets / Equity. Reducing credit lines shrinks the numerator; selling assets shrinks the numerator and plugs cash into the denominator; raising capital grows the denominator.
By pulling credit out of the economy, de-leveraging leads to deflation. Credit is a form of money just like cash. Removing it from the economy reduces the amount of dollars chasing goods and services, lowering prices. We’ve already seen this with housing prices of course: As mortgages are harder to come by, fewer people are able to buy a house. Demand falls relative to supply, so prices fall too.
Senators and Congressman may want the banks to lend more, but they simply don’t have sufficient equity capital on their balance sheets to do so.
Posted in Economy, accounting, bailout, banking, credit crunch, taxpayer issues |
18 Responses to “Understanding “De-leveraging,” Meredith Whitney on Credit Cards”
Those who save and invest will grow and prosper.
Those who borrow and spend will wither away.
Counterpole
By Counterpole on Dec 2, 2008
That credit lines have not already been pared back more substantially is truly shocking. Hank Paulson has not wanted to take away the punch bowl of excessive credit, since he fears the inevitable further reduction in consumer spending. So he encourages AmEx & Capital One to become banks so as to be eligible for TARP money. Just as families should be protecting themselves, not trying to spend money to stimulate the economny, banks should be protecting their shareholders & employees by protecting their balance sheets.
By John on Dec 2, 2008
Then the situation is - there was/is a whole lot of credit out there and, since you say it is another form of money, that means there was/is a whole lot of money that is simply evaporating.
That would make the “real” money that remains more valuable (deflation)
But at the same time the gov’t is pumping in its own credit (promise of future tax returns) trying desperately to offset the collapse and the deflation.
So barring anything that will get people to believe that the things that money can buy will be worth more tomorrow than they are today, we are in for a long term deflation no matter what the gov’t does - since all that it can throw at the problem can never approach the amount of credit that is now melting away, the gov’t playing along with companies that are pretending they are solvent.
Extrapolating - only when credit is vastly reduced to the point where the gov’t influx of money is a substantial part of the amount of credit remaining will there be a good chance of recovery.
Is this a gross simplification or am I on the right track?
By CB on Dec 2, 2008
You’re on the right track CB, check out this post I did awhile back regarding “Fed’s rationale for lowering rates despite inflation”.
You’ve keyed onto the points that spell out the conventional wisdom, that deflation is the risk, not inflation.
The wild-card is the prospect of capital flight. What if there is a sudden loss of confidence in the dollar due to the trillions of liabilities that the Fed/Treasury have taken onto their balance sheets?
By RolfeWinkler on Dec 2, 2008
Rolf simply bankruptcy of the united states in fact rather than the 9 ton elephant in the corner of the parlor
By gin on Dec 2, 2008
Meredith Whitney is right on the mark and has the guts to say it. The pathetic controlled US TV media is becoming increasingly irrelevant. Bloggers and opinion writers on the web are the only place for real information.
By Tom on Dec 2, 2008
Deflation - now that’s a foreign concept to anyone born in the USA in the last 70 years.
Credit has been too easy & too cheap. Borrowing money should subject to strict qualifications & an interest rate that provides the lender a good profit & gives the borrower pause to consider “is this really worth it”
An irony: Now, if people pull back & try to live within their means (isn’t living within your means a good thing?) it causes a recession or maybe a modern version of a depression.
Interesting times we live in.
By shinola on Dec 2, 2008
Great article!
By Mike on Dec 3, 2008
You people are in clouds.
Deflation?
Inflation is not the risk?
Borrowing money should [be]subject to strict qualifications & an interest rate that provides the lender a good profit & gives the borrower pause to consider “is this really worth it”?
I am astonished. By what? By a huge and omnipresent lack of any understanding of what is being done to you, folks. My guess is all those years of smoking marijuana did affected your thinking. Now, you’re not only the biggest commies yourself, but are also pretty dim ones at that.
Have you asked yourself a simple question: “why all the bailouts?” yet? No? Ha-ha! So, you really have no idea then? How come? I thought you’re the smartest, most free, and boldest!
How pathetic.
By George on Dec 3, 2008
In other words George, you have no idea what the article is about and no financial training / experience yourself.
By !George on Dec 3, 2008
Sounds like George has some debt he’s getting worried about…
By Hal on Dec 3, 2008
@ George, please explain what you are disgusted with. I truly would like to consider your strongly held viewpoint but I am not grokking it. Or is this simply a coke induced rant?
By gaucho on Dec 4, 2008
Yes if you borrow more than you can afford you will allways have to pay for it in the long run..
By Elias on Dec 5, 2008
This does not explain why, despite already having a credit card through them which I have not used in years, Citi sent me two unsolicited credit card applications the same day.
By Keith on Dec 5, 2008
I find this curious:
“My primary concern is preserving liquidity to consumers, who command more than two-thirds of gross domestic product.”
Isn’t it part of a fundamental problem in analysis that spending is considered part of our GDP? After all, it’s really debt, since that’s what spending creates.
No being able to spend is not necessarily a bad thing. We, as a nation, need to save.
N’est pas?
By Lisa on Dec 5, 2008
Lisa:
Ummm, no. GDP is the sum of all production within the nation’s borders. (Thus, the 50 states. Don’t think territories count, but I could be mistaken.) 75% of that production was consumed by inidividuals until recently; the remaining 25% was consumer by/produced for business buyers.
Spending doesn’t create debt.
The problem, which I think you’re trying to articulate, is the preponderance and availability of credit. The US has been on a credit binge for about 26 years. Now, credit is evaporating.
Inflation is the creation of money and credit. Since credit is steadily marching toward 0, the money supply is shrinking. Not holding steady. Shrinking. This is deflation. Credit is being destroyed.
What Whitney is saying in this op-ed is prevent the further destruction of credit (or at least slow the process, make it more orderly and calm). That destruction of credit comes in the form of lenders (Citi, BofA, JPM, COF et. al) cutting credit limits on cards. Real wages have not increased on an annual basis in almost 10 years. People have used credit cards to supplement (or replace) the increases in income they should have been getting in a growing economy. (The economy wasn’t really growing, but various measures were used to fool regular people - the American public - into believing it was. The biggest was low interest rates, which lowered the cost of credit, which made it easier to afford big houses, higher credit card balances, and other forms of debt.)
The measures Whitney calls for will slow the credit contraction, not end it. That gives people more time to pay off debt and other normalizations that need to occur to happen. If they happen sooner, it will add more stress on top of the already shaken economy. Eventually, those things will happen (FAS 140, etc.) but it gives regular people - US - breathing room.
George:
An obvious troll. Don’t feed the trolls. If he can’t explain his thinking intelligently and articulately, his thinking isn’t worth anything no matter how “brilliant” he may actually be. Communication is the most important human trait. He’s not proved himself human by any means.
Simply put: Deflation is the risk now, with the large holes in bank balance sheets. The capital being allocated to financials is not being lent out. Its filling the holes, as Meredith said. At some point, like when financials are (as an industry) solvent, lending resumes and inflation becomes the problem. Especially with all the money the Treasury and Fed have pumped into the economy. Hyperinflation can killed other empires; why should the US empire be any different?
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